4th Quarter 2011
After dropping double-digits during the third quarter, U.S. equity markets recovered nicely during the final quarter of the year, with the broad-market S&P 500 Index rallying more than 10%. After a sluggish first half of 2011, economic growth increased at a healthier rate during the second half of the year. A pick-up in consumer spending and ongoing solid gains in business investment contributed to third quarter economic growth, while fourth quarter real Gross Domestic Product (GDP) benefited from improved inventory and trade trends, along with continued gains in consumer spending.
Although the Eurozone debt crisis and the likelihood that Europe has entered a recession increase the risk to economic growth here in the U.S., we believe 2% GDP growth can be achieved in 2012. Job and income growth should be sufficient to support a moderate increase in consumer spending, but no more than that, as consumer debt levels remain high and personal savings rates are low. Business investment should experience another increase in 2012, supported by record levels of corporate profitability and some rebuilding of business inventories from 2011 levels. In addition, both housing starts and unit sales of autos and light trucks could show moderate improvement from depressed levels.
Still, the developed world simply has too much debt, and it will require time, patience, and sound fiscal policies to adequately reduce it in order to establish a solid foundation so that historical trend-line growth of closer to 3% can once again be achieved.
Up Year, Lagging Quarter
The Fund underperformed its custom 60% S&P 500 Index/40% Barclays US Government Credit Index benchmark during the fourth quarter, causing it to lag for the full year 2011. Given the big rally in equities, stock performance was the dominant factor in the Fund’s returns. An overweight allocation to Consumer Staples and underweight position in Energy, which positively contributed to relative results for the year, were among the main causes for lagging the index during the quarter. With the exception of Kraft, stock selection also lagged within the Consumer Staples, further detracting from relative returns during the fourth quarter.
Underweight positions in the surging Materials and Industrial sectors, an overweight to Healthcare, and cash also detracted from performance during the quarter. The Fund continues to hold a cash reserve, which served as a drag on returns amid the strong equity rally, due to weak economic data and the limited availability of additional monetary and fiscal stimulus.
Notable detractors among individual holdings included Oracle, Monsanto, and Bed Bath & Beyond. Oracle reported disappointing results, with earnings per share uncharacteristically missing consensus estimates by three cents. Results fell short across all products and geographies, leading us to trim the portfolio’s position. Monsanto was relatively weak within Materials even with higher inventories than forecasted, as corn stocks remain at multi-decade lows. With a less aggressive pricing strategy and several product cycles unfolding, we think the company seems poised to deliver strong volume/share gains even with modestly lower corn prices. Thus, we added to the position during the quarter. Bed Bath & Beyond disappointed some analysts’ high expectations for same store sales in its fiscal third quarter earnings report, despite upside in its earnings. We viewed the quarter favorably, with a healthy same-store sales increase on top of a series of strong numbers. We believe the company will be one of the faster growers among large-cap retailers and a long-term market share gain story, leading us to add to the position.
Overall stock selection in the Technology, Consumer Discretionary, and Energy sectors contributed positively to relative results for the quarter. Google, Visa, and Qualcomm within Technology all rose more than the sector. McDonald’s and Omnicom Group shined within Consumer Discretionary, with McDonald’s being reduced as the stock neared its all-time high and approached 5% of Fund assets. Omnicom was also eventually trimmed as about a third of its revenue comes from outside the U.S., which may be negatively affected by the European debt crisis.
Energy was the best performing sector in the index during the quarter. Although the Fund’s underweight position detracted overall from relative performance, stock selection within the sector outperformed. Among other individual stocks of note, pharmacy benefit manager Medco Health Solutions rose strongly. We increased the Fund’s position after the company reported earnings that exceeded expectations. We think the company should benefit from the announced merger with Express Scripts, which is expected to close during the first half of 2012.
Buys and Sells
Three new positions were added to the portfolio during the quarter—Cisco Systems, General Electric, and Unilever. Networking firm Cisco has become more streamlined and focused, with its restructuring program expected to generate approximately $1 billion in annual cost savings. We think strong free cash-flow and ample cash on its balance sheet can lead to higher dividends and increased share repurchases. The company is ideally positioned to benefit from continued growth in IP data traffic fueled by mobile, video and cloud technology.
We viewed diversified industrial manufacturer and service company General Electric as attractively valued given its nearly 4% dividend yield and leverage to late-cycle industries. In addition, we think conditions have improved at financial arm GE Capital. Unilever is a leading global consumer products company with a long tenure in Emerging Markets, faster growing regions that are now the source of 55% of the firm’s revenues. We think solid organic growth and a focus on improving operating margins could help the company to generate consistent double-digit earnings growth.
The position in JP Morgan, the Fund’s only Financials holding, was eliminated during the period. Although we had increased the position early in the quarter as the stock approached trough valuation levels from market lows in 1998, 2001 and 2008, we subsequently reduced and ultimately exited the position given its lack of relative earnings momentum.
Other noteworthy portfolio changes included the trimming of some Industrials and Technology names. Emerson Electric was reduced after the company reduced fiscal first quarter earnings guidance due to weaker than expected sales in its Network Power and Climate divisions. Fluor was trimmed after the stock rebounded nicely from recent lows and our concern about slowing economic growth. Within Technology, we eventually cut back on Accenture late in the quarter after having added to it earlier. A shift towards outsourcing versus consulting suggests to us entry into the later stages of the information technology services cycle. Finally, Apple was trimmed following the company’s uncharacteristic earnings miss. We believed upside was limited in the near-term as investors evaluated the competitive environment for the iPhone and iPad.
We believe the bond market will be range bound at low interest-rate levels to start the year. The ongoing European debt crisis is likely to keep demand for Treasury bonds strong as investors seek safety and liquidity. Interest-rates should remain low for most of 2012 as economic growth continues to be below trend due to continued deleveraging. We are maintaining a portfolio duration (sensitivity to movements in interest-rates) that is shorter than the fixed-income index as we think the total return upside is limited for longer maturity bonds given the overall low level of rates. We continue to favor high-quality intermediate-term Corporate bonds as the incremental yield offers investors additional income.
We expect a challenging and volatile stock market environment into the middle of 2012. With the U.S. economy expected to show very moderate growth, the European economy poised to enter a recession, and Emerging Market economies downshifting to reduced, but still above-average, rates of growth, global growth is slowing. Given this global slowdown and with corporate profitability already at record levels, investors are likely to be disappointed to find that corporate profit expectations for both the intermediate- and longer-term periods are generally too high. In addition to slowing economic and profit growth, investors will also have to contend with significant political uncertainty until U.S. voters determine which candidates can best solve our budget deficit, slower growth, and high unemployment problems. Clarity on these issues is unlikely until the middle of this year.
In our view, we are in the early stages of a rotation to higher-quality growth stocks such as those held in the Fund. In the challenging market environment that we expect in the months ahead, we believe these stocks may do particularly well as their valuations are attractive and their earnings growth is more assured. Longer-term, due to their financial strength and global diversification, we think these companies are positioned to provide sustained growth, and in many cases offer very attractive dividend yields in an environment where both growth and income yield will be scarce.
Montag & Caldwell Investment Counsel
As of December 31, 2011, Kraft Foods comprised 2.60% of the portfolio's assets, Oracle – 0.87%, Monsanto – 1.43%, Bed Bath & Beyond – 1.48%, Google – 2.70%, Visa – 1.76%, Qualcomm – 2.40%, McDonald’s – 2.47%, Omnicom Group – 1.23%, Medco Health Solutions – 1.43%, Cisco Systems – 1.10%, General Electric – 0.95%, Unilever – 0.75%, Emerson Electric – 0.83%, Fluor – 0.81%, Accenture – 1.42%, and Apple – 2.33%.
Note: The Fund is subject to stock and bond risk, and its value can decline through either market volatility or a rise in interest rates.
There is no guarantee that a company will pay out or continue to increase its dividends.
Before investing, carefully consider the fund’s investment objectives, risks, charges and expenses. Contact 800 992-8151 for a prospectus containing this and other information. Read it carefully. Aston Funds are distributed by BNY Mellon Distributors Inc.